Budgeting Basics and Beyond

20.9. Comparison of Methods

In general, the discounting cash flow methods (net present value, internal rate of return, and profitability index) come to the same conclusions for competing proposals. But these methods can give different rankings to mutually exclusive proposals in certain cases. Any one of these conditions can cause contradictory rankings:

• Project lives of different duration

• A higher cost for one project relative to another

• The trend in cash flow of one project that is the reverse of that of another

One of these characteristics of the company also may produce conflicting rankings:

• Future investment opportunities are expected to be different from at present, and the investor knows whether they will be better or worse.

• There is capital rationing, a maximum level of funding for capital investments.

The major cause for different rankings of alternative projects under present value and internal rate of return methods relates to the varying assumptions regarding the reinvestment rate employed for discounting cash flows. The net present value method assumes cash flows are reinvested at the cost of capital rate. The internal rate of return method assumes cash flows are reinvested at the internal rate.

Key point: The net present value method typically provides a correct ranking because the cost of capital is a more realistic reinvestment rate.

Recommendation: Which method is best for a business really depends on which reinvestment rate is nearest the rate the business can earn ...